By Carmen Bississo, CFP®, CLU®, CIMA®, AIF®, CLTC, CAS®, CFS®

Annuities can be a useful tool when considered in the context of a comprehensive financial plan. In order to maximize annuity benefits beyond just the annuity owner’s lifetime, it is important to consider the nuances of designating a beneficiary. Annuity beneficiary assignment is a crucial step in the estate planning process, as it can help heirs avoid probate and legal delays and help them access money faster.

From understanding the different types of beneficiaries to considering tax implications and aligning them with your overall financial goals, this article covers everything you need to know to be able to make informed decisions and enhance the value of your annuity.

What is an Annuity?

First, let’s define what an annuity is. An annuity is a contract between an individual (owner) and an insurance company. The individual makes a lump sum payment or a series of payments over time. In exchange, the insurance company agrees to pay out a guaranteed stream of income in retirement or at a predetermined future date, depending on the type of contract purchased. Most annuities also offer some death benefit protection.

To learn more about annuities and whether they make sense for your specific financial goals, check out our resource: Does an Annuity Make Sense for Me?

Tax Treatment of Annuities: Qualified vs. Non-Qualified

Before getting into beneficiary designation of annuities, it’s important to understand tax implications. When it comes to the tax treatment of annuities, there are two categories: qualified and non-qualified.

The main differences between qualified and non-qualified annuities lie in the tax treatment of contributions and withdrawals and the regulations around required distributions:

Qualified Annuities:

• • Funded with pre-tax dollars, often from retirement accounts like IRAs or 401(k)s
  • Contributions may be tax-deductible
  • Growth is tax-deferred, and withdrawals are taxed as ordinary income
  • Subject to required minimum distributions (RMDs)

Non-Qualified Annuities:

• • Funded with after-tax dollars
  • Contributions are not tax-deductible
  • Growth is tax-deferred, but only the earnings portion of withdrawals is taxed as ordinary income
  • Not subject to RMDs during the owner’s lifetime

Non-qualified annuities allow one to save more money, tax-deferred, for retirement, outside of traditional retirement vehicles such as 401k plans and IRAs with no limitations on the amount to be invested.

Deciding whether to invest in a qualified or nonqualified annuity will depend on your overall tax and retirement strategy.

This article focuses primarily on beneficiary assignment for non-qualified annuities. Qualified annuities follow the same payout rules as IRA accounts, and thus there aren’t many choices to consider that are particular to the annuity contract.

It is important to note that the choice of beneficiary for non-qualified annuities has a significant impact on how taxes are handled, as these annuities do not offer a step-up in basis at death.

Key Parties in an Annuity

There are three parties to all annuities:

• Owner
  • Can be a person or an entity
  • When applicable, the penalty for any premature distributions is
  • based on the owner’s age.
  • Usually the purchaser of the annuity has all the rights under the contract, subject to the rights of any irrevocable beneficiary
• Annuitant/ Insured
  • The annuitant must be a person
  • In many instances, the owner and the annuitant will be the same
  • Their life is used to determine the amount and duration of any annuity payments made under the contract
• Beneficiaries
  • The beneficiary receives the death benefit or any remaining annuity payments upon the death of the owner or annuitant, depending on contract type.

Why Assign Beneficiaries?

Annuities offer some unique planning benefits for future generations by allowing the owner to “control payment from death,” or choose how their beneficiaries should receive their proceeds at their passing.

Only the owner of an annuity can assign or change beneficiaries unless it’s an irrevocable assignment (which cannot be changed without the beneficiary’s consent).

Some people choose to invest in deferred annuities because they want to be able to name an irrevocable beneficiary without having to engage an attorney. However, the irrevocable beneficiary will have to sign off on any withdrawals the owner makes during his or her lifetime, which can be cumbersome.

Types of Beneficiaries

Annuity contracts allow for several beneficiaries, as well as contingent and tertiary beneficiaries. A contingent beneficiary, also known as a secondary beneficiary, will receive benefits if the primary beneficiary is unable to do so. A tertiary beneficiary is third in line, so they will receive assets if the primary and contingent beneficiaries are unable to do so.

The owner of the annuity contract can also state how beneficiaries should receive their share such as lump sum, non-qualified lifetime stretches, annuitization, payment over 10 years, etc.

Beneficiary Assignment & Tax Considerations for Non-Qualified Annuities

When a beneficiary inherits an annuity, the type of beneficiary assignment will affect how much tax they have to pay. Here’s what you should note about non-qualified annuities and beneficiary assignments:

Spouses

Assuming no conflict exists between spouses; the spouse should be listed as the primary beneficiary or joint owner to allow for spousal continuation. Annuities allow the spouse to continue to invest the assets tax-deferred in the annuity without experiencing a taxable event. The spouse will only have to pay taxes if they withdraw money, and those funds come from gains first (annuities use the LIFO accounting treatment for withdrawals and exclusion ratio for annuitization).

Other Beneficiaries

If there is no spouse, naming a person as a primary or contingent beneficiary often makes the most sense because they will have four main options for receiving funds when inheriting an annuity, one of which greatly reduces tax implications:

• 1. Non-qualified stretch
     The assets are kept in an annuity under the beneficiary’s name and the beneficiary has full control of the contract. The annuity payouts, and the required income taxes, are stretched out during the beneficiary’s lifetime. This is good for spreading out tax payments over time. The beneficiary must take at least a minimum distribution each year per IRS rules but can choose to take a lump sum and liquidate the contract at any time. This option usually offers most tax benefits for inherited annuities with large gains.
  2. Annuitization
     The beneficiary has the option to convert the lump sum inheritance into lifetime guaranteed income, forfeiting access to the lump sum in exchange for regular payments. This strategy is advantageous in high interest rate environments when the beneficiary requires consistent income and aims to leverage the exclusion ratio to minimize taxes on withdrawals. If 50% of the inherited value was gains, then 50% of the payment will be income taxed.
  3. Lump Sum Payment
     The beneficiary gets all of the money at once but has to pay taxes immediately on any gains in the inherited annuity.
  4. 5-Year Rule
     The beneficiary can keep the funds in the annuity for up to 5 years, taking out small withdrawals or all funds at any time within that 5-year period. They must withdraw all funds from the annuity by the end of the 5 years.
     

Trusts

Naming a trust as a beneficiary can help protect assets from creditors, but it removes the non-qualified stretch option for any remainder beneficiaries. Additionally, if assets are not distributed to remainder beneficiaries right away, income taxes paid on gains would be very high (at the trust’s tax rate level) and significant inheritance can be lost in the process.

Charities

For charitably inclined clients, naming a charity as a beneficiary can be a great option. An annuity with large gains makes for a great gift at death, as the charity would receive the full payment tax-free.

Conclusion

Although this can serve as a general guide, each annuity contract is unique, with different beneficiary options and rules. The options for who gets the money (the beneficiary) and when they get it (when the owner or the annuitant dies) can vary. Some annuity contracts also have various income and death benefit riders that can also impose restrictions on beneficiary assignment.

Because of these nuances, we recommend consulting with your financial advisor or insurance agent when it comes to making changes to annuity ownership or beneficiary assignment. They can help you analyze all of a product’s pros and cons so that you are able to maximize the transfer of funds to the next generation.

Disclosure: Material presented is meant for general illustration and/or informational purposes and should not be considered as personalized financial advice.